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Treasury & Capital Markets / Europe / Viewpoint
ECB premature rate cuts risk persistent inflation
By embarking on a new cycle of interest rate cuts now, the European Central Bank appears to be relying too heavily on flawed forecasts and ignoring economic and geopolitical realities. Faced with the risk of either cutting interest rates prematurely or maintaining an overly restrictive monetary policy, the ECB has not chosen wisely
Axel A. Weber 3 Jun 2024

With inflation in the eurozone dropping from a peak of 10.6% in October 2022 to 2.6% in May 2024, the European Central Bank (ECB) is optimistic that inflationary pressures will continue to ease. Its March projections show inflation averaging 2.3% in 2024, before falling to 2% in 2025 and 1.9% in 2026. Thus, the ECB is expected to cut its key policy rate, the deposit facility rate, from 4% to around 3.75% on June 6.

Markets foresee this as the first of many cuts that will substantially lower the ECB’s policy rates over the next two years. The signalling effect and the timing of the move are indeed significant, because this marks only the fifth time since the ECB’s inception (26 years ago) that it has initiated a new rate-cut cycle. But while a forward-looking monetary policy is commendable, it faces inherent limitations, particularly given the uncertainty of economic forecasts.

After all, predicting inflation beyond a one-year horizon is notoriously difficult, and this uncertainty has only increased in recent years. The ECB’s own failure to address the recent surge of inflation in a timely and effective manner was partly owing to inaccurate forecasts. Model-based forecasts, by design, tend to revert to historical averages in the medium term, and history also suggests that long-term inflation projections often converge to the central bank’s targets. Thus, the ECB’s forecasts showing declining inflation are partly a result of historical bias.

Moreover, the lingering effects of pandemic-related measures (such as inflated central bank balance sheets and higher fiscal deficits), coupled with economic sanctions on Russia, are also challenging to model and predict. Equally, additional geopolitical risks – including the Middle East conflict and escalating tensions between the United States and China – further complicate the inflation outlook, with most inflation risks tilting to the upside.

Structural changes also point toward higher inflation. Obvious sources of inflationary pressure include tight labour markets (driven by aging populations); extensive investments in the energy transition, energy security, and defence; deglobalization; and the eventual costs of rebuilding Ukraine.

Currently, the annual inflation rate in the eurozone remains above 2%, and recent trends are worrisome. Looking at consumer price levels (instead of growth rates) shows that, after a slight decline in late 2023, consumer prices have accelerated in 2024, rising at an annualized pace of 3.1% so far this year (measured by the seasonally adjusted Harmonized Index of Consumer Prices).

With consumer inflation above 2% and accelerating, historically low unemployment, and rapid wage growth (negotiated wages increased by 4.7% year on year in the first quarter), initiating a rate-cut cycle now could lead to another serious policy misstep. The ECB already erred previously, in 2021-22, when it based its monetary policy on faulty forecasts, and it now seems poised to repeat the mistake. Relying on undependable forecasts and ignoring current economic realities is not a forward-looking policy; it is a hope-based one.

Forecast uncertainty presents significant challenges for all central banks, since successful policymaking requires reasonably accurate foresight. As the reliability of forecasting wanes, effective risk-management becomes crucial. Under conditions characterized by a high degree of uncertainty, monetary policy must avoid significant errors, above all.

The ECB could make either of two potential mistakes: an overly restrictive policy or a premature easing. An overly restrictive policy could cause a recession and deflation, potentially threatening the stability of financial markets or real-estate prices. While undesirable, this scenario does not pose an existential threat to the eurozone. The ECB has ample leeway, tools and experience to combat deflation if necessary.

Conversely, premature easing could reignite inflation, forcing the ECB to reverse its initial cuts and to hike rates to higher levels than today. This scenario really could threaten the eurozone’s stability, as highly indebted member states might face unsustainable debt dynamics, with bond markets questioning their ability to repay. Central banks would then come under more pressure from governments, leading to fiscal dominance. If they are reluctant to do what is necessary, inflation could become persistent.

Persistent inflation, generated by an overly expansionary policy, is clearly the more perilous scenario. Yet this is precisely the risk that the ECB will be taking by launching a new rate-cutting cycle now. A premature shift to easing could undermine its credibility and heighten future inflation risks. By overlooking the asymmetry of risks, the ECB is exhibiting poor risk management. Central banks should not allow market pressures to dictate their policies. Premature easing is a dangerous gamble.

Axel A. Weber is a co-chair of the Bretton Woods Committee Multilateral Reform Working Group and a former chairman at UBS Group and president of the Deutsche Bundesbank.

Copyright: Project Syndicate

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